1 part i the international financial environment multinational corporation (mnc)foreign exchange...

Chapter 1Chapter Objectives
To identify the main goal of the MNC and conflicts with that goal;
To describe the key theories that justify international business; and
To explain the common methods used to conduct international business.
Goal of the MNC
The commonly accepted goal of an MNC is to maximize shareholder wealth.
For corporations with shareholders who differ from their managers, a conflict of goals can exist - the agency problem.
Agency costs are normally larger for MNCs than for purely domestic firms, but can vary with the management style of the MNC.
Goal of the MNC
Various forms of corporate control can reduce agency problems - stock compensation, threat of hostile takeover, monitoring by large shareholders.
As MNC managers attempt to maximize their firm’s value, they may be confronted with various environmental, regulatory, or ethical constraints.
Theories of International Business
Theory of Comparative Advantage
Imperfect Markets Theory
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2
3
Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs.
4a
Firm differentiates product from competitors and/or expands product line in foreign country.
4b
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International Trade - a relatively conservative approach involving exporting and/or importing.
Licensing - provision of technology in exchange for fees or some other benefits.
Franchising - provision of a specialized sales or service strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees.
International Business Methods
Joint Ventures - joint ownership and operation by two or more firms.
Acquisitions of Existing Operations
Establishing New Foreign Subsidiaries
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Marginal Return on Projects
Marginal Cost of Capital
Appropriate Size for MNC
Removal of the Berlin Wall in 1989
Single currency system in 1999
Opportunities in Latin America
International Opportunities
Exposure to International Risk
exchange rate fluctuations affect cash flows and foreign demand
Exposure to Foreign Economies
economic conditions affect demand
Exposure to Political Risk
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U.S.-based MNC
$ for products
$ for supplies
$ for exports
$ for imports
U.S. Businesses
Foreign Importers
U.S. Customers
Foreign Exporters
Profile B: MNCs focused on International Trade and International Arrangements
U.S.-based MNC
$ for products
$ for supplies
$ for exports
$ for imports
$ for service
Profile C: MNCs focused on International Trade, International Arrangements, and Direct Foreign Investment
$ for products
$ for supplies
$ for exports
$ for imports
$ for service
Domestic Model (Present value of expected cash flows)
where E (CF$,t ) = expected cash flows to be
received at the end of period t
n = the number of periods into the future in
which cash flows are received
k = the required rate of return by investors
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Valuing International Cash Flows
in currency j to be received by the
U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which
currency j can be converted to
dollars at the end of period t
k = the weighted average cost of capital of
the U.S. parent company
More Exposure to Exchange Rate Risk
New International Opportunities
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Background on International Financial Markets (Chapters
2-5)
Long-Term Investment and Financing Decisions (Chapters 13-18)
Short-Term Investment and Financing Decisions (Chapters 19-21)
Exchange Rate Risk Management (Chapters 9-12)
Risk and Return of MNC
Value and Stock Price of MNC
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Impact of MNC’s Management Style on Agency Costs
Impact of Corporate Control on Agency Costs
Constraints Interfering with the MNC’s Goal
Theories of International Business
Theory of Comparative Advantage
Exposure to Foreign Economies
Exposure to Political Risk
Valuation Model for an MNC
Domestic Model
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Chapter Objectives
To explain the key components of the balance of payments; and
To explain how the international flow of funds is influenced by economic factors and other factors.
Balance of Payments
The balance of payments is a measurement of all transactions between domestic and foreign residents over a specified period of time.
The recording of transactions is done by double-entry bookkeeping.
The balance-of-payments statement can be broken down into various components, the chief ones being the current account and the capital account.
Balance of Payments
The current account represents a summary of the flow of funds between one specified country and all other countries due to the purchases of goods or services, or the provision of income on financial assets, over a specified period of time.
The current account is commonly used to assess the balance of trade, which is the difference between merchandise exports and merchandise imports.
Balance of Payments
The capital account represents a summary of the flow of funds resulting from the sale of assets between one specified country and all other countries over a specified period of time.
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Exports
Europe
23%
$153b
Canada
International Trade Flows
Since the 1970s, international trade has grown for most countries. The recent value of U.S. exports and imports is more than eight times the 1975 value.
Since 1976, the value of U.S. imports has exceeded the value of U.S. exports, causing a balance of trade deficit.
Recent Changes in North American Trade
A free trade pact between U.S. and Canada was initiated in 1989 and completely phased in by 1998.
In 1993, the North American Free Trade Agreement (NAFTA), which removed numerous trade restrictions among Canada, Mexico, and the U.S., was passed.
Momentum for free enterprise in Eastern Europe
Single currency system in 1999
Trade Agreements Around the World
In 1993, a General Agreement on Tariffs and Trade (GATT) accord calling for lower tariffs was made among 117 countries.
Friction Surrounding Trade Agreements
Dumping refers to the exporting of products by one country to other
countries at prices below cost.
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Inflation
A relative increase in a country’s inflation rate will decrease its current account.
National Income
A relative increase in a country’s income level will decrease its current account.
Factors Affecting International Trade Flows
Government Restrictions
An increase in the tariffs on imported goods will increase the country’s current account.
A government can also reduce its country’s imports by enforcing a quota.
Exchange Rates
If a country’s currency begins to rise in value, its current account balance will decrease.
Note that the factors are interactive, such that their simultaneous influence is complex.
Correcting a Balance of Trade Deficit
By reconsidering the factors that affect the balance of trade, some common correction methods can be developed.
However, a weak home currency may not necessarily improve a trade deficit due to:
revised pricing policy by foreign competition,
weakening of some other currencies,
trade prearrangements (J curve effect), and
intracompany trade.
Capital flows usually represent direct foreign investment or portfolio investment.
The DFI positions in the U.S. and outside the U.S. have risen substantially over time, indicating increasing globalization.
DFI by U.S. firms are mainly targeted at the United Kingdom and Canada, while much of the DFI in the U.S. comes from the United Kingdom, Japan, the Netherlands, Germany, and Canada.
Factors Affecting DFI
Changes in Restrictions
New opportunities may arise from the removal of government barriers.
Privatization
DFI has also been stimulated by the movement toward free enterprise.
Potential Economic Growth
Countries that have more potential economic growth are more likely to attract DFI.
Tax Rates
Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI.
Exchange Rates
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Tax Rates on Interest or Dividends
Investors assess their potential after-tax earnings from investments in foreign securities.
Interest Rates
Money tends to flow to countries with high interest rates.
Exchange Rates
If a country’s home currency is expected to strengthen, foreign investors may be attracted.
Agencies that Facilitate International Flows
International Monetary Fund (IMF)
IMF goals encourage increased internationalization of business.
Its compensatory financing facility attempts to reduce the impact of export instability on country economies.
Financing by the IMF is measured in special drawing rights.
World Bank
The primary objective of the profit-oriented bank is to make loans to countries in order to enhance economic development.
The World Bank may spread its funds by entering into cofinancing agreements.
A recently established agency offers various forms of political risk insurance.
World Trade Organization
This was established to provide a forum for multilateral trade negotiations and to settle trade disputes related to the GATT accord.
International Financial Corporation (IFC)
The IFC promotes private enterprise within countries through loans and stock purchases.
International Development Association (IDA)
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The BIS facilitates international transactions among countries. It is the “central banks’ central bank” and the “lender of last resort.”
Regional Development Agencies
These agencies, such as the Inter-American Development Bank and the Asian Development Bank, have regional objectives relating to economic development.
Impact of International Trade on an MNC’s Value
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S. parent
Trade Agreements
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U.S. Balance of Trade Trend
Recent Changes
Friction Surrounding Trade Agreements
Inflation ¤ Government Restrictions
Why a Weak Home Currency is Not a Perfect Solution
International Capital Flows
Distribution of DFI by U.S. Firms and in the U.S.
Chapter Review
International Monetary Fund
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Chapter Objectives
To describe the background and corporate use of the following international financial markets:
foreign exchange market,
Motives for Using International Financial Markets
Several barriers deter the complete integration of the markets for real or financial assets.
Examples include tax differentials, tariffs, quotas, labor immobility, cultural differences, financial reporting differences, and costs of communication.
Yet, these barriers can also create unique opportunities for specific geographic markets that will attract foreign creditors and investors.
Motives for Using International Financial Markets
Motives for investing in foreign markets:
economic conditions
high foreign interest rates
low interest rates
exchange rate expectations
Foreign Exchange Market
The foreign exchange market allows currencies to be exchanged to facilitate international trade or financial transactions.
The system for establishing exchange rates has changed over time:
1876-1913: gold standard
1944: Bretton Woods Agreement
There is no specific building or location where traders exchange currencies. Trading also occurs around the clock.
The market for immediate exchange is known as the spot market.
Trading between banks makes up what is often referred to as the interbank market.
The forward market for currencies enables an MNC to lock in the exchange rate (called a forward rate) at which it will buy or sell a currency.
Attributes of banks important to customers in need of foreign exchange:
competitiveness of quote
speed of execution
forecasting advice
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The bid/ask spread is normally greater for those currencies that are less frequently traded.
Exchange rate quotations for widely traded currencies are listed in many newspapers on a daily basis. Forward rates and cross exchange rates may be quoted too.
cross exchange rate :
Quotations that represent the value of a foreign currency in dollars are referred to as direct quotations, while those that represent the number of units of a foreign currency per dollar are referred to as indirect quotations.
bid/ask spread
currency A in units =
Some MNCs involved in international trade use the currency futures and options markets to hedge their positions.
Futures are similar to forward contracts, except that they are sold on an exchange while forward contracts are offered by banks.
Currency options are classified as either calls or puts. They can be purchased on an exchange too.
Eurocurrency Market
U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars and are not subject to U.S. regulations.
In the 1960s and 70s, the Eurodollar market, or what is now called the Eurocurrency market, grew to accommodate increasing international business.
The market is made up of several large banks called Eurobanks that accept deposits and provide loans in various currencies.
Eurocurrency Market
Although the market focuses on large-volume transactions, at times no single bank is willing to lend the needed amount. A syndicate of Eurobanks may then be composed.
Two regulatory events allow for a more competitive global playing field:
The Single European Act opens up the European banking industry and calls for similar regulations.
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Eurocurrency Market
The Eurocurrency market in Asia is sometimes referred to separately as the Asian dollar market.
The primary function of banks in the Asian dollar market is to channel funds from depositors to borrowers. Another function is interbank lending and borrowing.
Eurocredit Market
Loans of one year or longer extended by Eurobanks to MNCs or government agencies are called Eurocredit loans. These loans are provided in the Eurocredit market.
Eurocredit loans often have a floating rate, to lessen the risk resulting from a mismatch in the banks’ asset and liability maturities.
Syndicated Eurocredit loans are popular among big borrowers too.
Eurobond Market
There are two types of international bonds:
A foreign bond is issued by a borrower foreign to the country where the bond is placed.
Eurobonds are sold in countries other than the country represented by the currency denominating them.
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Eurobond Market
Eurobonds increased rapidly in volume when in 1984, the withholding tax was abolished in the U.S. and corporations were allowed to issue bonds directly to non-U.S. investors.
Interest rates for each currency and credit conditions change constantly, causing the market’s popularity to vary among currencies.
In recent years, governments and corporations from emerging markets have frequently utilized the Eurobond market.
Why Interest Rates Vary Among Currencies
Interest rates, which can vary substantially for different currencies, are crucial because they affect the MNC’s cost of financing.
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Why U.S. Dollar Interest Rates Differ from Brazilian Real Interest Rates (for loanable funds)
The curves are further to the right for the dollar because the U.S. economy is larger.
The curves are higher for the Brazilian Real because of the higher inflation in Brazil.
Quantity of $
Global Integration of Interest Rates
Many investors shift their savings around currencies to take advantage of higher interest rates.
Borrowers sometimes also borrow a currency different from what they need to take advantage of a lower interest rate.
Ultimately, the freedom to transfer funds across countries causes the demand and supply conditions for funds to be integrated, which in turn causes interest rates to be integrated.
International Stock Markets
MNCs can obtain funds by issuing stock in international markets, in addition to the local market.
By having access to various markets, the stocks may be more easily digested, the image of the MNC may be enhanced, and the shareholder base may be diversified.
The proportion of individual versus institutional ownership of shares varies across stock markets. The regulations are different too.
The locations of the MNC’s operations may affect the decision about where to place stock, in view of the cash flows needed to cover dividend payments in the future.
Stock issued in the U.S. by non-U.S. firms or governments are called Yankee stock offerings.
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Foreign cash flow movements of a typical MNC:
Foreign trade. Exports generate foreign cash inflows, while imports require cash outflows.
Direct foreign investment. Cash outflows to acquire foreign assets generate future inflows.
Short-term investment or financing in foreign securities, usually in the Eurocurrency market.
Longer-term financing in the Eurocredit, Eurobond, or international stock markets.
Impact of Global Financial Markets on an MNC’s Value
E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t
Cost of borrowing funds in global markets
Cost of parent’s equity in global markets
Cost of parent’s funds borrowed in global markets
Improved global image from issuing stock in global markets
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Motives for Investing in Foreign Markets
Motives for Providing Credit in Foreign Markets
Motives for Borrowing in Foreign Markets
Foreign Exchange Transactions
Bid/Ask Spread of Banks
Direct versus Indirect Quotations
Eurocurrency Market
Syndicated Eurocurrency Loans
Asian Dollar Market
Why Interest Rates Vary Among Currencies
Global Integration of Interest Rates
How Financial Markets Affect an MNC’s Value
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To explain how the equilibrium exchange rate is determined; and
To examine the factors that affect the equilibrium exchange rate.
Measuring Exchange Rate Movements
An exchange rate measures the value of one currency in units of another currency.
A decline in a currency’s value is referred to as depreciation, while an increase is referred to as appreciation.
% D in foreign currency value = (S - St-1) / St-1
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Exchange Rate Equilibrium
An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to supply.
Value of £
Quantity of £
Relative Inflation Rates
A relative increase in U.S. inflation will increase the U.S. demand for British goods, and hence the U.S. demand for British pounds.
In addition, the British desire for U.S. goods, and hence the supply of pounds, will drop.
Value of £
Quantity of £
Relative Interest Rates
A relative rise in U.S. interest rates will decrease the U.S. demand for British pounds.
In addition, the supply of pounds by British corporations will increase.
Value of £
Quantity of £
Real Interest Rates
A relatively high interest rate may reflect expectations of relatively high inflation, which may discourage foreign investment.
Real interest rates adjusts nominal interest rates for inflation:
real nominal
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Relative Income Levels
A relative increase in the U.S. income level will increase the U.S. demand for British goods, and hence the demand for British pound.
The supply of pounds does not change.
Value of £
Quantity of £
Government Controls
Governments can influence the equilibrium exchange rate in many ways, including :
the imposition of foreign exchange barriers,
the imposition of foreign trade barriers,
intervening in the foreign exchange market, and
affecting macro variables such as inflation, interest rates, and income levels.
Factors that Influence Exchange Rates
Expectations
Foreign exchange markets react to any news that may have a future effect.
Institutional investors often take currency positions based on anticipated interest rate movements in various countries too.
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Trade-Related
Factors
U.S. demand for foreign goods, i.e. demand for foreign currency
Foreign demand for U.S. goods, i.e. supply of foreign currency
U.S. demand for foreign securities, i.e. demand for foreign currency
Foreign demand for U.S. securities, i.e. supply of foreign currency
Exchange rate between foreign currency and the dollar
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Interaction of Factors
Trade-related factors and financial factors sometimes interact. For example, an increase in income levels sometimes causes expectations of higher interest rates.
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How Factors Have Influenced Exchange Rates
Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts measure the dollar’s strength with an index.
Dollar’s Index
inflation
high U.S. interest rates, a somewhat depressed U.S. economy, and low inflation
large balance of trade deficit
high U.S. interest rates
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.
1. Borrows $20 million
2. Holds NZ$40 million
3. Receives NZ$40,216,000
Exchange at $0.52/NZ$
4. Holds $20,912,320
Returns $20,120,000
Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.
1. Borrows NZ$40 million
2. Holds $20 million
3. Receives $20,112,000
Exchange at $0.48/NZ$
4. Holds NZ$41,900,000
Returns NZ$40,232,000
Exchange Rates on an MNC’s Value
Inflation rates
Interest rates
Income levels
Government controls
Chapter Review
Relative Inflation Rates
Relative Interest Rates
Relative Income Levels
How Exchange Rate Determination Affects an MNC’s Value
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Chapter Objectives
To explain how forward contracts are used to hedge based on anticipated exchange rate movements;
To explain how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements; and
To explain how currency options contracts are used to speculate or hedge based on anticipated exchange rate movements.
Forward Market
A forward contract is an agreement between a corporation and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future.
When MNCs anticipate future need or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate.
Forward contracts are not normally used by consumers or small firms.
Forward Market
If the forward rate exceeds the existing spot rate, it contains a premium. If it is less than the existing spot rate, it contains a discount.
Suppose spot rate = $1.681, and
90-day forward rate = $1.677.
discount $1.681 90
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Forward Market
Non-deliverable forward contracts (NDFs) are forward contracts whereby the currencies are not actually exchanged. Instead, a net payment is made by one party to the other based on the contracted rate and the market exchange rate on the day of settlement.
While the NDF does not involve delivery, it can effectively hedge future foreign currency cash flows that are anticipated by the MNC.
Currency Futures Market
Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date, typically the third Wednesdays in March, June, September, and December.
The contracts can be traded by firms or individuals on the trading floor of an exchange, on automated trading systems, or over the counter.
Size of contract ¤ Marketplace
Clearing operation
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Holders of futures contracts can close out their position by selling an identical futures contract. Similarly, sellers of futures contracts can close out their position by purchasing a currency futures contract with a similar settlement date.
The gain or loss to the firm is dependent on the difference between the purchase price and the sale price.
Most currency futures contracts are closed out before their settlement date.
The contracts are guaranteed by the exchange clearinghouse, and margin requirements are imposed to cover fluctuations in value.
Corporations that have open positions in foreign currencies can use futures contracts to offset such positions.
Speculators also use them to capitalize on their expectation of a currency’s future movement.
Brokers who fulfill orders to buy or sell futures contracts earn a transaction fee in the form of a bid/ask spread.
Currency Options Market
A currency option is another contract that can be bought or sold by speculators and firms.
The standard options that are traded on an exchange through brokers are guaranteed.
In contrast, the options that are tailored to the specific needs of the firm are offered by commercial banks and brokerage firms in an over-the-counter market. There are no credit guarantees for these options.
Currency options are classified as either calls or puts.
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Currency Call Options
A currency call option grants the right to buy a specific currency at a specific price (called the exercise or strike price) within a specific period of time.
A call option is in the money when the present exchange rate exceeds the strike price, at the money when the rates are equal, and out of the money otherwise.
Option owners will at most lose the premiums they paid for their options.
the level of existing spot price relative to strike price,
the length of time before the expiration date, and
the potential variability of the currency.
Corporations can use currency call options to cover their foreign currency positions.
Unlike a futures or forward contract, if the anticipated need does not arise, the firm can choose to let the options contract expire. The firm can also sell or exercise the option.
Individuals may also speculate in the currency options market based on their expectations of the future movements in a particular currency.
When brokerage fees are ignored, the currency call buyer’s gain will be the seller’s loss if both parties begin and close out their positions at the same time.
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Currency Put Options
A currency put option grants the right to sell a specific currency at a specific price (the strike price) within a specific period of time.
A put option is in the money when the present exchange rate is less than the strike price, at the money when the rates are equal, and out of the money otherwise.
Since option owners are not obligated to exercise their options, they will at most lose the premiums they paid.
the level of existing spot price relative to strike price,
the length of time before the expiration date, and
the potential variability of the currency.
Corporations can use currency put options to cover their foreign currency positions.
Individuals may also speculate with currency put options based on their expectations of the future movements in a particular currency.
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$1.46
$1.50
$1.54
- $.02
- $.04
- $.06
+$.06
+$.04
+$.02
$1.46
$1.50
$1.54
- $.02
- $.04
- $.06
+$.06
+$.04
+$.02
Conditional Currency Options
Some options are structured with the premium conditioned on the actual movement in the currency’s value over the period of concern.
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basic put $1.70 - $0.02
$1.66
$1.68
$1.70
$1.72
$1.74
$1.76
$1.78
$1.80
$1.66
$1.70
$1.74
$1.78
$1.82
European-style currency options are similar to American-style options except that they can only be exercised on the expiration date.
For firms that purchase options to hedge future foreign currency cash flows, this loss in terms of flexibility is probably not an issue. Hence, if their premiums are lower, European-style currency options may be preferred.
Efficiency of
If foreign exchange markets are efficient, speculation in the currency futures and/or currency options markets should not consistently generate abnormally large profits.
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on an MNC’s Value
Currency futures
Currency options
Premium or Discount on the Forward Rate
Non-Deliverable Forward Contracts
Pricing Currency Futures
Credit Risk of Currency Futures Contracts
Corporate Use of Currency Futures
Speculation with Currency Futures
Currency Options Market
Break-Even Point from Speculation
Speculating with Combined Put and Call Options
Contingency Graphs for Options
Efficiency of Currency Futures and Options
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locational
arbitrage
triangular
arbitrage
© 2000 South-Western College Publishing
To describe the exchange rate systems used by various governments;
To explain how governments can use direct intervention to influence exchange rates;
To explain how governments can use indirect intervention to influence exchange rates; and
To explain how government intervention in the foreign exchange market can affect economic conditions.
Exchange Rate Systems
Exchange rate systems can be classified according to the degree to which exchange rates are controlled by the government.
Exchange rate systems normally fall into one of the following categories:
fixed
Fixed Exchange Rate Systems
In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.
Examples: Bretton Woods era (1944-1971)
Smithsonian Agreement (1971)
Pros: Work becomes easier for the MNCs. Cons: The government may alter the value of
a specific currency.
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In a freely floating exchange rate system, exchange rates are determined by market forces without intervention by governments.
Pros:
¤ World stability is enhanced as problems
experienced by one country may not easily spread to other countries.
¤ No intervention policies are needed and
governments are not restricted by exchange rate boundaries when setting new policies.
¤ Less capital flow restrictions are needed, thus
enhancing the efficiency of the financial market.
Freely Floating
resources to managing exposure to exchange rate fluctuations.
¤ The country that initially experienced economic
problems (such as high inflation, increasing unemployment rate) may have its problems compounded.
Managed Float
A managed float or “dirty” float exchange rate system resembles the freely floating system in that rates are allowed to fluctuate freely on a daily basis. Yet, it is like the fixed system in that governments may intervene to prevent the rates from moving too much in one direction.
It has been pointed out that a government can manipulate exchange rates such that its own country benefits at the expense of others.
Examples: Korea (1997), Russia (1997)
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Pegged Exchange Rate Systems
In a pegged exchange rate system, the home currency’s value is pegged to a foreign currency or to some unit of account, and moves in line with that currency or unit against other currencies.
Examples:
The European Economic Community’s snake arrangement (1972-1979)
The European Monetary System’s exchange rate mechanism (ERM) (1979-1999)
The ERM experienced severe problems in the fall of 1992, as economic conditions and goals varied among European countries.
Speculators make it even more difficult for a currency board to defend its position against pressures exerted by economic conditions.
Note that the local interest rates must be aligned with the interest rates of the currency to which the local currency is tied.
How will a country (called PEG) whose currency is pegged to the U.S. dollar be affected when the currency of another country (called FLOAT) fluctuates against the dollar?
When FLOAT’s currency depreciates against the dollar (and hence against PEG’s currency), FLOAT exports more to and imports less from both the U.S. and PEG. The volume of trade between the U.S. and PEG decreases too.
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The Euro
On January 1, 1999, the euro was introduced. By 2002, the national currencies of the participating countries will be withdrawn from the financial system and replaced with the euro.
The Frankfurt-based European Central Bank is responsible for setting a common monetary policy. It aims to control inflation and to stabilize the value of the euro.
As currency movements among the European countries will be eliminated, more long-term business arrangements between firms of European countries will be encouraged.
The Euro
Non-European firms can also compare European products and European firms more easily, as their values are denominated in the same currency.
Cross-border investing may increase due to the elimination of exchange rate risk. However, non-European investors may not achieve as much diversification as in the past.
Government Intervention
Each country has a government agency (called the central bank) that may intervene in the foreign exchange markets to control the value of the country’s currency.
In the United States, the Federal Reserve System (Fed) is the central bank.
Central banks manage exchange rates
to smooth exchange rate movements,
to establish implicit exchange rate boundaries, and/or
to respond to temporary disturbances.
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in the Foreign Exchange Market
Value of £
Quantity of £
When the change in money supply is not adjusted for, the intervention is said to be nonsterilized. A sterilized intervention occurs when Treasury securities are bought or sold simultaneously to maintain the money supply.
Some speculators attempt to determine when the central bank is intervening, and the extent of the intervention, in order to capitalize on the anticipated results.
The central bank can also intervene indirectly by influencing the factors that determine a currency’s value, such as interest rates.
Note that high interest rates adversely affects local borrowers, and may weaken the economy.
Some governments also use foreign exchange controls (such as restrictions on the exchange of the currency) as a form of indirect intervention.
Exchange Rate Target Zones
Many economists have criticized the present system because of the wide swings in the exchange rates of major currencies.
It has been suggested that target zones be used, whereby an initial exchange rate will be established with specific boundaries.
The ideal target zone should allow rates to adjust to economic factors without causing wide swings in international trade and fear in financial markets. However, the actual result may be a system no different from what exists today.
Intervention as a Policy Tool
The exchange rate is a tool, like tax laws and money supply, with which the government can use to achieve its desired economic objectives.
A weak home currency can stimulate foreign demand for products (and hence local jobs), but may lead to higher inflation.
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Government Intervention in
Direct intervention
Indirect intervention
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Pegged Exchange Rate System
Currency Boards
Chapter Review
Impact on the Valuation of Businesses in Europe
Impact on Financial Flows
Influence of a Weak Home Currency on the Economy
Influence of a Strong Home Currency on the Economy
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Chapter Objectives
To explain the conditions that will result in various forms of international arbitrage, along with the realignments that will occur in response to the various forms of international arbitrage; and
To explain the concept of interest rate parity, and how it prevents arbitrage opportunities.
International Arbitrage
Arbitrage can be defined as capitalizing on a discrepancy in quoted prices. Often, the funds invested are not tied up and no risk is involved.
Locational arbitrage is possible when the bid price of one bank is higher than the ask price of another bank for the same currency.
e.g. Bank A Bank B
dollars -> pounds pounds -> dollars
$1.61 / £ $1.62 / £
In response to the imbalance in demand and supply resulting from such arbitrage activity, the prices will adjust very quickly.
Triangular arbitrage is possible when a quoted cross exchange rate differs from that calculated using the appropriate spot rates.
e.g. Bank A Bank B Bank C
$ -> £ £ -> Canadian$ Canadian$ -> $
Note: Calculated cross rate = 0.50625£ / C$
*
Covered interest arbitrage tends to force a relationship between the interest rates of two countries and their forward exchange rate.
e.g. Borrow $ at 3%, or use existing funds
which are earning interest at 2%.
Convert $ to £ at $1.60/£ and engage in a
90-day forward contract to sell £ at $1.60/£.
Lend £ at 4%.
In response to the imbalance in demand and supply resulting from such arbitrage activity, the rates will adjust very quickly.
Locational arbitrage ensures that quoted exchange rates are similar across banks in different locations.
Triangular arbitrage ensures that cross exchange rates are set properly.
Covered interest arbitrage ensures that forward exchange rates are set properly.
Any discrepancy will trigger arbitrage, which will then eliminate the discrepancy. Arbitrage thus makes the foreign exchange market more orderly.
Interest Rate Parity
When market forces cause interest rates and exchange rates to be such that covered interest arbitrage is no longer feasible, the equilibrium state achieved is referred to as interest rate parity (IRP).
When IRP exists, the rate of return achieved from covered interest arbitrage should equal the rate available in the home country. By simplifying and rearranging terms:
forward = (1 + home interest rate) _ 1
premium (1 + foreign interest rate)
*
6-month U.S. dollar interest rate = 5% ,
then from the U.S. investor’s perspective,
forward = (1 + .05) _ 1 = _ .9434%
premium (1 + .06) (not annualized)
If the peso’s spot rate is $.10/peso,
then the 6-month forward rate
= spot rate x (1 + premium)
= .10 x (1 _ .009434) = $.09906/peso
The relationship between the forward rate and the interest rate differential can be simplified and approximated as follows:
forward = forward rate - spot rate
premium spot rate
interest rate interest rate
*
Interest Rate Differential (%)
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1
3
- 1
- 3
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1
3
- 3
- 1
Zone where covered interest arbitrage is not feasible
*
IRP generally holds. Where it does not hold, covered interest arbitrage may still not be worthwhile due to transaction costs, currency restrictions, differential tax laws, political risk, etc.
When IRP exists, it does not mean that both local and foreign investors will earn the same returns.
*
Correlation Between Spot and Forward Rates
Because of interest rate parity, a forward rate will normally move in tandem with the spot rate. This correlation depends on interest rate movements.
t0
t2
t1
Impact of Arbitrage on an MNC’s Value
Forces of Arbitrage
Numerical Example
Interpretation of Interest Rate Parity
Considerations When Assessing Interest Rate Parity
Correlation Between Spot and Forward Rates
Impact of Arbitrage on an MNC’s Value
*
© 2000 South-Western College Publishing
Chapter Objectives
To explain the purchasing power parity (PPP) theory and its implications for exchange rate changes;
To explain the international Fisher effect (IFE) theory and its implications for exchange rate changes; and
To compare the PPP theory, IFE theory, and theory of interest rate parity (IRP).
Purchasing Power Parity
When a country’s inflation rate rises relatively, decreased exports and increased imports depress the country’s currency. The theory of purchasing power parity (PPP) focuses on this inflation - exchange rate relationship.
The absolute form is the “law of one price.” It suggests that similar products in different countries should be equally priced when measured in the same currency.
The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas.
When inflation occurs and PPP holds, the exchange rate will adjust to maintain the parity:
Pf (1 + If ) (1 + ef ) = Ph (1 + Ih )
where Ph = price index of goods in the home country
Pf = price index of goods in the foreign country
Ih = inflation rate in the home country
If = inflation rate in the foreign country
ef = % change in the foreign currency’s value
Since Ph = Pf , solving for ef gives:
ef = (1 + Ih ) _ 1
ef » Ih _ If
This formula is appropriate only when the inflation differential is small.
Suppose that the inflation rate in U.S. is 9%, while U.K.’s rate is 5%. Then PPP suggests that the £ should appreciate by about 4%.
*
Inflation Rate Differential (%)
%D in the foreign currency’s spot rate
- 2
- 4
2
4
1
3
- 1
- 3
Inflation Rate Differential (%)
- 2
- 4
2
4
1
3
- 1
- 3
*
If the actual inflation differential and exchange rate % change for two or more countries deviate significantly from the PPP line over time, then PPP does not hold.
A statistical test can be developed by applying regression analysis to the historical exchange rates and inflation differentials:
ef = a0 + a1 { (1+Ih)/(1+If) - 1 } + m
The appropriate t-tests are then applied to a0 and a1, whose hypothesized values are 0 and 1 respectively.
PPP may not occur consistently due to:
the existence of other influential factors like differentials in income levels and risk, as well as government controls; and
the lack of substitutes for traded goods.
A limitation in testing PPP is that the results may vary according to the base period used.
PPP can also be tested by assessing a “real” exchange rate over time. If this rate reverts to some mean level over time, this would suggest that it is constant in the long run.
International Fisher Effect
According to the Fisher effect, nominal risk-free interest rates contain a real rate of return and an anticipated inflation.
If the same real return is required across countries, differentials in interest rates may be due to differentials in expected inflation.
According to PPP, exchange rate movements are caused by inflation rate differentials.
*
According to the IFE, the expected effective return on a foreign investment should equal the effective return on a domestic investment:
(1 + if ) (1 + ef ) _ 1 = ih
where ih = interest rate in the home country
if = interest rate in the foreign country
ef = % change in the foreign currency’s value
Solving for ef : ef = (1 + ih ) _ 1
(1 + if )
*
Interest Rate Differential (%)
- 2
- 4
2
4
1
3
- 1
- 3
While the IFE theory may hold during some time frames, there is evidence that it does not consistently hold.
A statistical test can be developed by applying regression analysis to the historical exchange rates and nominal interest rate differentials:
ef = a0 + a1 { (1+ih)/(1+if) - 1 } + m
The appropriate t-tests are then applied to a0 and a1, whose hypothesized values are 0 and 1 respectively.
Since the IFE is based on PPP, it will not hold when PPP does not hold.
According to the IFE, the high interest rates in southeast Asian countries before the Asian crisis should not attract foreign investment because of exchange rate expectations.
However, since narrow bands were being maintained by some central banks, some foreign investors were motivated.
*
Forward Rate
Impact of Inflation on an MNC’s Value
Effect of Inflation
Chapter Review
Tests of the IFE
Application of the IFE to the Asian Crisis
Comparison of IRP, PPP, and IFE Theories
*
Information on existing and anticipated economic conditions of various countries and on historical exchange rate movements
Information on existing and anticipated
cash flows in
Forecasting exchange rates
*
To explain how firms can benefit from forecasting exchange rates;
To describe the common techniques used for forecasting; and
To explain how forecasting performance can be evaluated.
Why Firms Forecast Exchange Rates
MNCs need exchange rate forecasts for their:
hedging decisions,
earnings assessment.
Forecasting Techniques
Technical forecasting involves the use of historical data to predict future values. It includes statistical analysis and time series models, and is similar to the technical forecasting of stock prices.
Speculators may find technical forecasting models useful for predicting day-to-day movements. For MNCs however, their use may be limited, since they typically focus on the near future, and rarely provide point or range estimates.
Fundamental forecasting is based on the fundamental relationships between economic variables and exchange rates.
A forecast may arise simply from a subjective assessment, or it can be based on quantitative measurements.
*
Known relationships like the PPP can also be used. However, problems may arise because:
¤ the timing of the impact of inflation fluctuations
on trade behavior is not known for sure,
¤ the relative prices may be measured
inaccurately,
that should emerge according to PPP,
¤ other factors that affect exchange rates exist.
¤ the uncertain timing of the impact of factors,
¤ the need for forecasts for factors with
instantaneous impact,
omitted from the model,
Market-based forecasting involves developing forecasts from market indicators.
Usually, either the spot rate or the forward rate is used, since they should reflect the market expectation of the future rates.
For long-term forecasting, the quoted interest rates on risk-free instruments can be used to determine what the forward rates should be under conditions of interest rate parity.
*
Mixed forecasting refers to the use of a combination of forecasting techniques.
The actual forecast is a weighted average of the various forecasts developed.
Forecasting Services
The corporate need to forecast currency values has prompted some consulting firms and banks to offer forecasting services.
Advice on international cash management, assessment of exposure to exchange rate risk and hedging may be provided too.
One way to determine whether a forecasting service is valuable is to compare the accuracy of its forecasts with the accuracy of publicly available and free forecasts.
Evaluation of Forecast Performance
An MNC that forecasts exchange rates should monitor its performance over time to determine whether its forecasting procedure is satisfactory. The MNC will also want to compare its various forecasting methods.
One such measure is the absolute forecast error as a percentage of the realized value:
| forecasted value - realized value |
realized value
*
Evaluation of Forecast Performance
Note that the degree of forecast accuracy may vary for different currencies. For example, the value of a less volatile currency is likely to be forecasted more accurately.
If the errors are consistently positive or negative over time, then there is a bias in the forecasting procedure.
The following regression model can test for bias: actual_rate = a0 + a1 ¡¦ forecast + m
*
Perfect forecast line
Forecasting Under Market Efficiency
If the foreign exchange market is weak-form efficient, then the current exchange rates already reflect historical information. So, technical analysis would not be useful.
If the market is semistrong-form efficient, then all the relevant public information is already reflected in the current exchange rates.
If the market is strong-form efficient, then all the relevant public and private information is already reflected in the current exchange rates.
Forecasting Exchange Rate Volatility
MNCs also forecast exchange rate volatility. This enables them to develop best-case and worst-case scenarios along with their point estimate forecasts.
Several methods are possible:
movements as a forecast.
previous periods.
Application of Exchange Rate Forecasting to the Asian Crisis
Before the crisis, the spot rate served as a reasonable predictor, while the use of fundamental factors was not as suitable, because of intervention by the central banks.
But even after the crisis began, it is unlikely that the degree of depreciations could have been accurately predicted by the usual models.
The two key factors leading to the sharp decline in the Asian currency values are:
the large amount of foreign investment, and
the fear of a massive selloff of the currencies.
*
Impact of Forecasted Exchange Rates
on an MNC’s Value
Technical forecasting
Fundamental forecasting
Market-based forecasting
Mixed forecasting
Technical Forecasting
Fundamental Forecasting
Market-Based Forecasting
Mixed Forecasting
Forecasting Services
Forecasting Under Market Efficiency
Forecasting Exchange Rate Volatility
*
Chapter Objectives
To discuss the relevance of an MNC’s exposure to exchange rate risk;
To explain how transaction exposure can be measured;
To explain how economic exposure can be measured; and
To explain how translation exposure can be measured.
Is Exchange Rate Risk Relevant?
Purchasing Power Parity Argument:
PPP does not necessarily hold.
The Investor Hedge Argument:
MNC shareholders can hedge against exchange rate fluctuations on their own.
The investors may not have complete information on corporate exposure. They may not have the capabilities to correctly insulate themselves too.
Is Exchange Rate Risk Relevant?
Currency Diversification Argument:
An MNC that is well diversified should not be affected by exchange rate movements because of offsetting effects.
This is a naive presumption.
Stakeholder Diversification Argument:
Well diversified stakeholders will be somewhat insulated against losses experienced by an MNC due to exchange rate risk.
MNCs may be affected in the same way because of exchange rate risk.
Types of Exposure
Transaction exposure
Economic exposure
Translation exposure
Transaction Exposure
The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure.
Two steps are involved in measuring transaction exposure:
determine the projected net amount of inflows or outflows in each foreign currency, and
determine the overall risk of exposure to those currencies.
To determine the overall risk, assess the standard deviations and correlations of the currencies, taking into account the size of the MNC’s position in each currency in terms of a standard currency.
The standard deviation statistic on historical data measures currency variability. Note that the variability may change over time.
Correlation coefficients indicate the degree to which two currencies move in relation to each other. They may change over time too.
A related method, the value-at-risk (VAR) method, incorporates currency volatility and correlations to determine the potential maximum one-day loss.
Historical data is used to determine the potential one-day decline in a particular currency. This decline is then applied to the net cash flows in that currency.
Economic Exposure
Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations.
*
Impact of Local Currency Appreciation on Transactions
Impact of Local Currency Depreciation on Transactions
Local sales (relative to foreign competition in local markets)
Firm’s exports denominated in local currency
Firm’s exports denominated in foreign currency
Interest received from foreign investments
Decrease
Decrease
Decrease
Decrease
Increase
Increase
Increase
Increase
Impact of Local Currency Appreciation on Transactions
Impact of Local Currency Depreciation on Transactions
Firm’s imported supplies denominated in local currency
Firm’s imported supplies denominated in foreign currency
Interest owed on foreign funds borrowed
No Change
Economic Exposure
Even purely domestic firms can be affected by economic exposure if there is foreign competition within the local markets. However, their degree of exposure is likely to be much less than for MNCs.
One method of measuring economic exposure is by reviewing how the earnings forecast in the income statement changes in response to alternative exchange rate scenarios.
Economic Exposure
Another method of assessing a firm’s economic exposure is by applying regression analysis to historical cash flow and exchange rate data as follows:
% D in the inflation - % D in the
adjusted cash flows exchange
measured in the = a0 + a1 x rate of the + m
firm’s home currency currency
over period t over period t
The model can be varied by including more currencies, using an index of currencies, focusing on selected cash flows only, or using the stock price.
Translation Exposure
The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure.
Translation exposure may not be relevant because translating financial statements for consolidated reporting purposes does not affect an MNC’s cash flows.
*
Note that the current translation of earnings may be a useful base to derive the expected future cash flows when earnings are remitted by the foreign subsidiaries to the parent.
Translation exposure is dependent on:
the degree of foreign involvement by foreign subsidiaries,
the locations of foreign subsidiaries, and
the accounting methods used.
According to estimates, the total translated earnings of U.S.-based MNCs were reduced by $20 billion in the third quarter of 1998 alone simply because of the depreciation of Asian currencies against the dollar.
*
Impact of Exchange Rate Exposure
on an MNC’s Value
Transaction exposure
Economic exposure
Purchasing Power Parity Argument
The Investor Hedge Argument
Transaction Exposure Based on Currency Variability & Currency Correlations
Transaction Exposure Based on Value-at-Risk
Economic Exposure
Economic Exposure of Domestic Firms & MNCs
Measuring Economic Exposure
Sensitivity of Cash Flows to Exchange Rates
Chapter Review
The Locations of Foreign Subsidiaries
The Accounting Methods Used
*
To identify the commonly used techniques for hedging transaction exposure;
To explain how each technique can be used to hedge future payables and receivables;
To compare the advantages and disadvantages among hedging techniques; and
To suggest other methods of reducing exchange rate risk when hedging techniques are not available.
Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations.
However, on the average, hedging may not reduce the MNC’s costs.
If transaction exposure exists, the MNC should
identify the degree of transaction exposure,
decide whether to hedge and how much to hedge based on its degree of risk aversion and exchange rate forecasts, and
choose among the various hedging techniques available if it decides to hedge.
MNCs that adopt a centralized approach to hedging must identify the net transaction exposure in each currency for all its subsidiaries.
Note that sometimes, a firm can reduce its transaction exposure by pricing its exports in the same currency that will be needed to pay for imports.
Techniques to Eliminate Transaction Exposure
A futures hedge involves the use of currency futures to hedge transaction exposure.
Recall that futures contracts represent a standardized number of units for each currency.
*
A forward hedge involves the use of forward contracts by large corporations to hedge transaction exposure.
Based on the firm’s degree of risk aversion, the decision about whether to hedge can be made by comparing the known result of hedging to the possible results of remaining unhedged.
For payables :
cost of = of payables – of payables
hedging with hedging without hedging
For receivables :
nominal nominal
cost of = revenues – revenues
without hedging with hedging
If the real cost is negative, then hedging is more favorable than not hedging.
To estimate the real cost, the probability distribution of the exchange rates is needed:
expected probability real cost
of hedging i rate is i when rate is i
The overall probability that hedging will be more costly can also be computed.
*
A money market hedge involves taking one or more money market position to cover a future payables or receivables position.
Often, two positions are required:
For payables, (1) borrow the home currency representing future payables, and (2) invest in the foreign currency.
For receivables, (1) borrow the foreign currency representing future receivables, and (2) invest in the home currency.
If interest rate parity (IRP) exists, and transaction costs do not exist, the money market hedge will yield the same results as the forward hedge.
This is so because the forward premium on the forward rate reflects the interest rate differential between the two currencies.
A currency option hedge involves the use of currency call or put options to hedge transaction exposure.
Recall that the option owner can choose not to exercise the contract.
Hence, the firm will be insulated from adverse exchange rate movements, but may benefit from favorable movements.
However, the firm must assess whether the advantages are worth the premium paid for the option.
Most MNCs determine which hedging technique is optimal on a case-by-case basis.
Note that when using a futures, forward, or money market hedge, the firm can determine its future cash flows with certainty. However, this is not the case when using a currency option hedge or when remaining unhedged.
*
Hedging Long-Term Transaction Exposure
Over the long run, the continual hedging of repeated transactions that are expected in the near future has limited effectiveness.
Hence, MNCs that are certain of their future cash flows may attempt long-term hedging.
The commonly used techniques are long-term forward contracts, currency swaps, and parallel loans.
Long-term forward contracts, or long forwards, with maturities of ten years or more, can be set up for very creditworthy customers.
Currency swaps can take many forms. In one form, two parties, with the aid of brokers, agree to exchange specified amounts of currencies on specified dates in the future.
A parallel loan, or back-to-back loan, involves an exchange of currencies between two parties, with a promise to re-exchange the currencies at a specified exchange rate on a future date.
Alternative Hedging Techniques
Sometimes, a firm may not be able to eliminate its transaction exposure completely because it cannot accurately predict its cash flows, or because the costs of hedging are too high.
To reduce exposure under such conditions, the firm can consider leading and lagging, cross-hedging, or currency diversification.
The act of leading and lagging refers to an adjustment in the timing of payment request or disbursement to reflect expectations about future currency movements.
Alternative Hedging Techniques
When a currency cannot be hedged, cross-hedging may be practiced. With cross-hedging, a currency that is highly correlated with the currency of concern is hedged instead. The stronger the positive correlation, the more effective the strategy will be.
*
Impact of Hedging Transaction Exposure
on an MNC’s Value
Hedging decisions on
Adjusting the Invoice Policy to Manage Exposure
Futures Hedge
Forward Hedge
Determining the Optimal Hedge
*
Chapter Objectives
To explain how an MNC’s economic exposure can be hedged; and
To explain how an MNC’s translation exposure can be hedged.
Economic Exposure
Economic exposure refers to the impact exchange rate fluctuations can have on a firm’s future cash flows. Recall that cash flows can be affected in ways not directly associated with foreign transactions.
The management of economic exposure tends to result in a long-term solution. Its importance can be seen from the bankruptcy of Laker Airways, and from the impact the 1997/8 Asian crisis had on firms.
Economic Exposure
A firm can assess its economic exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios.
The firm can then reduce its exposure by restructuring its operations.
Economic Exposure
For example, a firm may attempt to balance its exchange-rate-sensitive revenues and expenses by :
1. increasing or reducing sales in new or existing
foreign markets,
foreign suppliers,
in foreign markets, and/or
denominated in foreign currencies.
Economic Exposure
Note that computer spreadsheets can be very helpful in assessing alternative scenarios.
MNCs must be very confident about the long-term potential benefits before they proceed to restructure their operations, because of the high costs of reversal.
Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial reporting.
Some firms are concerned about translation exposure because of its potential impact on reported consolidated earnings, and may attempt to avoid it by matching its foreign liabilities with its foreign assets.
To hedge translation exposure, forward contracts can be used.
For example, a U.S.-based MNC that is concerned about the translated value of its British earnings may enter a one-year forward contract to sell pounds.
If the pound depreciates during the fiscal year, the gain generated from the forward contract position may offset the translation loss.
inaccurate earnings forecasts,
accounting distortions, and
increased transaction exposure.
*
Impact of Hedging Economic Exposure
on an MNC’s Value
Hedging decisions on
Assessing Economic Exposure
Expediting the Analysis with Computer Spreadsheets
Issues Involved in the Restructuring Decision
Managing Translation Exposure
Limitations of Hedging Translation Exposure
Alternative Solution to Hedging Translation Exposure
How Economic Exposure Management Affects an MNC’s Value
*
Existing
Potential Revision in Host Country Tax Laws or Other Provisions
Estimated Cash Flows of Multinational Project
Required Return on Multinational Project
Multinational Capital Budgeting Decisions
To describe common motives for initiating direct foreign investment; and
To illustrate the benefits of international diversification.
Motives for Direct Foreign Investment
There are several ways in which DFI can boost revenues or reduce costs :
1. Attract new sources of demand, especially
when growth is limited in the home country.
2. Enter markets in which superior profits are
possible.
especially for firms that utilize much
machinery.
5. Use foreign raw materials.
6. Use foreign technology.
for firms that possess resources or skills
not available to competing firms.
8. React to exchange rate movements. DFI can
be considered when the foreign currency
appears to be undervalued. DFI can also
help reduce economic exposure.
10. Diversify internationally.
The optimal method for a firm to penetrate a foreign market is partially dependent on the characteristics of the market.
Before investing in a foreign country, the potential benefits must be weighed against the costs and risks.
As conditions change over time, the potential benefits from pursuing DFI in various countries change too.
Benefits of
International Diversification
expected return i on business unit i
overall variance = S pi2si2 + S S pi pj Covij
i i j,j ¹i
where pi = % of funds invested in business unit i
si2 = variance of the return on business unit i
Covij = covariance between the returns on
business unit i and business unit j
*
Benefits of International Diversification
When a firm invests in foreign projects, the overall return will be more stable because of the lower correlations between the returns of projects implemented in different economies.
Domestic
An MNC with projects positioned around the world is concerned about the risk and return characteristics of the projects.
Frontier
The actual location of the frontier of efficient project portfolios depends on the business in which the firm is involved.
Expected Return
a single-product MNC
Efficient frontier of
project portfolios for
a multi-product MNC
Some periodic decisions are necessary:
Should further expansion take place?
Should the earnings be remitted to the parent, or used by the subsidiary?
Host Government View of DFI
DFI may provide needed employment or technology. However, locally owned companies may lose business due to the new competition.
*
Impact of Direct Foreign Investment Decisions on an MNC’s Value
DFI decisions on type
of business and location
Decisions Subsequent to DFI
*
Chapter Objectives
To compare the capital budgeting analysis of an MNC’s subsidiary with that of its parent;
To demonstrate how multinational capital budgeting can be applied to determine whether an international project should be implemented; and
To explain how the risk of international projects can be assessed.
Subsidiary versus Parent Perspective
Should a parent or its subsidiary conduct the capital budgeting for a multinational project?
The results may vary with the perspective because the net after-tax cash inflows to the parent can differ substantially from those to the subsidiary.
The difference in cash inflows is due to :
1. tax differentials
2. restricted remittances
3. excessive remittances
Cash Flows Generated by Subsidiary
After-Tax Cash Flows to Subsidiary
Cash Flows Remitted by Subsidiary
Withholding Tax Paid
to Host Government
The following forecasts are normally required:
1. initial investment 2. consumer demand
3. price 4. variable cost
5. fixed cost 6. project lifetime
7. salvage (liquidation) value 8. fund-transfer restrictions
9. tax laws 10. exchange rates 11. required rate of return
Multinational Capital Budgeting
Capital budgeting is necessary for all long-term projects that deserve consideration.
One method of performing the analysis is to calculate the net present value of the project:
net n cash flow salvage
present = _ initial + S in period t + value
value outlay t =1 (1+ k )t (1+ k )n
k = required rate of return on the project
n = lifetime of the project (number of periods)
If the net present value is positive, the project may be accepted.
Factors to Consider in Multinational Capital Budgeting
A variety of factors may affect the capital budgeting analysis :
1. Exchange rate fluctuations - Different
scenarios should be considered together with their probability of occurrence.
2. Inflation - Inflation can be quite volatile
from year to year in some countries.
3. Financing arrangement - Many foreign
projects are partially financed by foreign subsidiaries.
*
4. Blocked funds - Some countries may
require that the earnings be reinvested locally for a certain period of time before they can be remitted to the parent.
5. Uncertain salvage value - The salvage
value typically has a significant impact on the project’s net present value.
6. Impact of project on prevailing cash flows.
7. Host government incentives.
Adjusting Project Assessment for Risk
If an MNC is unsure of the cash flows of a proposed project, it needs to adjust its assessment for this risk.
One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger the discount rate that is applied.
Many computer software packages are also available to perform sensitivity analysis and simulation.
Impact of Multinational Capital Budgeting Decisions on an MNC’s Value
Multinational capital
budgeting decisions
E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t
*
Multinational Capital Budgeting
Exchange Rate Fluctuations
Host Government Incentives
Risk-Adjusted Discount Rate
*
Chapter Objectives
To provide a background on how MNCs use international acquisitions as a form of multinational restructuring;
To explain how MNCs conduct valuations of foreign target firms;
To explain why valuations of a target firm vary among MNCs that plan to restructure by acquiring a target; and
To identify other types of multinational restructuring.
Multinational Restructuring
Decisions by an MNC to build a new subsidiary, to acquire a company, to sell an existing subsidiary, to downsize some of its operations, or to shift some production from one subsidiary to another, represent different forms of multinational restructuring.
MNCs continuously assess possible forms of multinational restructuring to capitalize on changing economic, political and industrial conditions across countries.
International Acquisitions
Through an international acquisition, a firm can immediately expand its international business, since the structure is already in place, and customer relationships have already been established.
*
*
All countries have one or more agencies that monitor mergers and acquisitions. MNCs need to be aware of the barriers that may be imposed by them.
Examples of such barriers include laws against hostile takeovers, restricted foreign majority ownership, “red tape”, and special requirements.
The cost of overcoming the barriers should be taken into consideration when acquiring a foreign company.
One method of valuing a foreign target is to calculate its net present value :
net n cash flow salvage
present = _ initial + S in period t + value
value outlay t =1 (1+ k )t (1+ k )n
k = required rate of return on the acquisition
n = lifetime of the acquired company
Note that the relevant exchange rates, taxes and blocked-funds restrictions should be taken into account.
If the net present value is positive, the foreign company may be acquired.
During the Asian crisis, some MNCs capitalized on the low property values, weakened currencies, and the need for funds by many firms, to invest in Asia. These MNCs must not ignore the adverse effects of the crisis too.
*
Factors that Affect the Expected Cash Flows of the Foreign Target
Target-Specific Factors
1. Target’s previous cash flows 2. Managerial talent of the target
Factors that Affect the Expected Cash Flows of the Foreign Target
Country-Specific Factors 1. Target’s local economic conditions
2. Target’s local political conditions 3. Target’s industrial conditions
4. Target’s currency conditions 5. Target’s local stock market conditions
6. Taxes applicable to the target
The Valuation Process
The MNC first conducts an initial screening of the prospective targets to identify those that deserve a closer assessment.
The MNC then values each of the targets that passed the screening process by calculating their net present values, for example.
Only those targets with positive net present values will be further considered.
If the MNC decides not to bid for a target at this time, it will need to redo its analysis the next time it reconsiders acquiring the target.
Why Valuations of a Target May Vary Among MNCs
The target’s expected future cash flows varies.
Different MNCs will manage the target’s operations differently.
Each MNC may have a different plan for fitting the target within the structure of the MNC.
Acquirers based in certain countries may be subjected to less taxes on remitted earnings.
The effect of exchange rates varies.
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The required rate of return varies.
Different MNCs may have different plans for the target, with different levels of risk.
The local risk-free interest rate may be different for MNCs based in different countries.
MNCs in some countries have more flexibility in their ability to use financial leverage.
Other Types of Multinational Restructuring
An MNC may engage in a partial international acquisition of a firm, by purchasing a portion of the existing stock of a foreign firm.
The valuation of the firm will vary depending on whether the MNC plans to acquire enough shares to control the firm.
Many MNCs also acquire businesses that are being sold by governments all over the world.
It is usually difficult to measure the value of these privatized businesses because of the many uncertainties surrounding the transition.
MNCs commonly engage in international alliances, such as joint ventures and licensing agreements, with foreign firms.
The initial outlay is typically smaller, but the cash flows to be received will be smaller too.
An MNC should also conduct periodic assessments to determine whether to retain its foreign investments or to divest them.
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Impact of Multinational Restructuring Decisions on an MNC’s Value
Multinational restructuring decisions
Assessing Potential Acquisitions in Asia and Europe
Factors that Affect the Expected Cash Flows
Target-Specific Factors
Country-Specific Factors
Why a Target’s Value May Vary Among MNCs
Expected Cash Flows From the Target
Exchange Rate Effects on Remitted Funds
Required Return of the Acquirer
International Partial Acquisitions
International Alliances
International Divestments
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Chapter Objectives
To identify the common factors used by MNCs to measure a country’s political risk;
To identify the common factors used by MNCs to measure a country’s financial risk;
To explain the techniques used to measure country risk; and
To explain how the assessment of country risk is used by MNCs when making financial decisions.
Why Country Risk Analysis Is Important
Country risk represents the potentially adverse impact of a country’s environment on the MNC’s cash flows.
Country risk can be used :
to monitor countries where the MNC is presently doing business;
as a screening device to avoid conducting business in countries with excessive risk; and
to improve the analysis used in making long-term investment or financing decisions.
Political Risk Factors
Some consumers may be very loyal to local products.
Attitude of Host Government
The host government may impose special requirements, restrictions, or additional taxes, subsidize local firms, or fail to enforce copyright laws.
Blockage of Fund Transfers
Political Risk Factors
The MNC parent may need to exchange earnings for goods.
War
Internal and external battles, or even the threat of war, can have a devastating effect.
Bureaucracy
Corruption
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Financial Risk Factors
One financial factor is the current and potential state of the country’s economy.
A recession can severely reduce demand.
Financial distress can also encourage the government to restrict the MNC’s operations.
A country’s economy is dependent on other financial factors, such as interest rates, exchange rates, and inflation.
Government purchasing power indicators, such as the budget deficit, are also important if the government is a customer of the MNC.
Types of Country Risk Assessment
A macro-assessment of country risk is an overall risk assessment of a country without consideration of the MNC’s business.
A micro-assessment of country risk is the risk assessment of a country as related to the MNC’s type of business.
The overall assessment of country risk thus consists of :
1. Macro-political risk 3. Micro-political risk
2. Macro-financial risk 4. Micro-financial risk
Types of Country Risk Assessment
Risk assessors often differ in opinion due to subjectivities in :
identifying the relevant political and financial factors,
determining the relative importance of each factor, and
predicting the values of the factors.
Techniques to Assess Country Risk
A checklist approach involves measuring all the identified factors and assigning weights to them.
The Delphi technique involves collecting independent opinions on country risk.
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Comparing Risk Ratings Among Countries: The Foreign Investment Risk Matrix (FIRM)
Techniques to Assess Country Risk
Inspection visits involve traveling to a country and meeting with government officials, firm executives, and/or consumers.
In some cases, it may be most appropriate to use a combination of two or more techniques.
Unclear
Zone
Acceptable
Zone
Unacceptable
Zone
1. Assign values and weights to the political risk factors.
2. Multiply the factor values with their respective weights, and sum up to give the political risk rating.
3. Derive the financial risk rating similarly.
4. Assign weights to the political and financial ratings according to their perceived importance.
5. Multiply the ratings with their respective weights, and sum up to give the overall country risk rating.
Incorporating Country Risk in Capital Budgeting
Adjustment of the Discount Rate
The higher the perceived risk, the higher the discount rate applied to the project’s cash flows.
Adjustment of the Estimated Cash Flows
By analyzing each possible impact, the MNC can determine the probability distribution of the net present values for the project.
Applications of Country Risk Analysis
While the overall risk rating of a country can be useful, it cannot always detect upcoming crises.
The Persian Gulf crisis is an example of how a country’s risk can change over time.
Through the 1997/8 Asian crisis, MNCs realized that they had underestimated the potential financial problems that could occur in the high-growth Asian countries.
Reducing Exposure to Host Government Takeovers
Use a Short-Term Horizon
Rely on Unique Supplies or Technology
In this way, the host government will not be able to take over and operate the subsidiary successfully.
Hire Local Labor
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Borrow Local Funds
Purchase Insurance
Many home countries of MNCs have investment guarantee programs that insure to some extent the risks of expropriation, wars, or currency blockage.
Similar programs may be offered by the host country or an international agency too.
Impact of Country Risk on an MNC’s Value
E (CFj,t ) = expected

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